Will FNMA And FMCC Bring Extraordinary Returns To Investors This Summer?

The failure of legislative reform of the housing market and the potential windfall that investors stand to gain should a favorable decision be made on the plaintiffs’ case make Fannie Mae (FNMA) and Freddie Mac (FMCC) the most divisive stocks currently trading. This summer, the issue comes to a head with greater urgency and more at stake than ever before. The timing of key financial, legal and legislative factors are converging spelling volatility for the GSEs stocks in the months to come:

An exterior view of mortgage finance giant Fannie Mae is seen May 23, 2006 in Washington, DC. (Photo by Alex Wong/Getty Images)

The pending earning reports due from the GSEs (August 2nd and 4th for FMCC and FNMA respectively) will likely draw increased attention to the deteriorating financial health of the two companies. The consequences of the net worth sweep have left cash reserves at precariously low levels of less than $2.5 billion for both Fannie Mae and Freddie Mac, making it difficult for them to withstand any fluctuations in their profitability. While healthy and profitable in the long run, the two companies’ quarterly earning can be volatile due to their business sensitivity to fluctuation in interest rates. The 10 year notes hit record low yields this month of 1.35% which will negatively impact earnings. Prevented from building a capital buffer by the introduction of the Third Amendment and with only a little more than $1 billion each left to cover any losses, a substantial Q2 loss for FNMA or FMCC would almost certainly result in another draw from the Treasury. Even if a draw is narrowly avoided this quarter, the two companies will inevitably need an infusion of capital in the near future.

It is difficult to assess the impact of another government “bailout” for investors. On one hand, this could ultimately be to the benefit of investors, as a Q2 draw would likely attract the spotlight of popular political media to the ongoing tug of war for the fate of the GSEs and their current mismanagement and spur action including potentially allowing the GSEs to build up their capital reserves again. On the other hand, a further draw on the Treasury prior to the resolution of the outstanding legal battle could make it much harder for the plaintiffs to justify their case, if not in the eyes of the federal appeals panel, then certainly in the eyes of the public. Traumatic experiences of 2008 still loom large in Main Street’s memory, so regardless of the fact that the net worth sweep authorized by the government will directly lead to a new ‘bailout”, a draw would still hurt the public’s perception of the plaintiffs’ case.

Legislative reform so far has been impossible as few politicians seam to agree what type of system should replace the GSEs. There have been a number of failed attempts for a legislative reform. Furthermore, the risks of tinkering with the US housing market are great making a significant reform daunting. Thus, any meaningful legislative action prior to the election remains unlikely.

A newly elected president, however, will be better positioned to enact change. For example, Hilary Clinton has shared her views on the restructuring of the firms in the past. Her plan would likely call for the merging of the twins as well as the implementation of some sort of catastrophic loss backstop which would mean the placement of a large buffer of private capital before government (and therefore taxpayers) would absorb any losses. Although what happens to current shareholders is not mentioned, it is implied that such a reform would not be favorable to investors.

Given the rising financial and legislative risks above, investors face a race against time. Ideally a legal outcome will be handed down before the capital situation of the GSEs deteriorates further. Thus, the most likely driver for a significant windfall for investors comes from the courts:

The legal picture has dramatically improved during the appeals process. Attorney Tom Ogden at Wollmuth Maher and Deutsch LLP provided some insight on the possible legal outcomes for the current appeals case. Mr. Ogden believes that it would be reasonable to expect a decision in this case before years’ end. There are three clear possible outcomes with distinct impact on the GSEs stocks’ future value:

An outright affirmation of Judge Lamberth's ruling:

Given the highly unusual introduction of new evidence in the case before the appellate case by the plaintiffs, and the favorable nature of said evidence, this seems to be a very low probability outcome. Furthermore, considering the traditionally conservative leanings of Justices Ginsberg and Janice Brown, this seems to be the least likely outcome. In the unlikely scenario that Judge Lamberth’s ruling is affirmed, the plaintiffs could successfully bring their case before the Supreme Court. Although this would be a long shot and further delays the process.

An outright reversal of Judge Lamberth's ruling:

This is the second least likely probability, since appeals cases are typically made on previously established facts. The opening of more than 120 previously sealed documents in the appeals case currently before Justices Ginsberg, Brown, and Millet seems to have significantly increased the prospects of investors realizing a significant return, which did not look promising after the Lamberth prior ruling. The new evidence demonstrates inconsistencies in the government’s defense and potential wrong-doing. It is now plausible to prove that the government instituted the net worth sweep to prevent the GSEs from becoming profitable and overstepped its legitimate rights.

A remand back to Judge Lamberth from the Federal appeals panel with stipulations:

The third scenario is a remand of the case back to Judge Lamberth with specific guidance how to proceed. Many observers, including Mr. Ogden, see this as the most likely outcome. A partial reversal of some kind may also accompany such a remand, with some specific rulings against what Judge Lamberth did.

If the second scenario were to play out successfully, it would undoubtedly be the most beneficial outcome for investors. In this scenario it is highly like that both stocks could potentially reach a market value of $20, a price frequently cited by Bill Ackman, or more. Many observers have called for a 12-14x return on current share price in the event of a reversal of Lamberth’s ruling that enables recapitalization. The third scenario could potentially boost the two’s stock prices as well, rising on the back of speculative buying. Tan affirmation of Judge Lamberth’s ruling would likely render the stocks close to worthless for the foreseeable future.

From an investment perspective, the GSE stocks are not for the faint-hearted and remain highly risky. The “good” news for investors is that a resolution is possible before the end of the year and the likelihood of a favorable legal outcome has become more likely.

The history of how we got here is messy and controversial:

Fannie Mae and Freddie Mac were originally created with the purpose of “promoting access to mortgage credit through the nation…by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing” U.S.C § 1716(3). The design ensured government intervention to effectively subsidize homeownership.

A particularly unique aspect of the US mortgage system, the fixed-rate mortgage loan, is made possible by the stability and liquidity FNMA and FMCC. No other nation offers such a product, instead issuing their mortgage loans on a floating interest rate basis. This arrangement essentially shifts massive amounts of risk from private investors to the US government. The unique relationship between the GSEs and the private markets is a double-edged sword. It in effect allows thousands of Americans to become homeowners and at the same time, can encourage excessive risk taking ultimately destabilizing the housing market.

On July 30, 2008, Congress enacted the Housing and Economic Recovery Act (“HERA”), authorizing the Treasury to invest in the GSEs on the basis of the “systematic danger that a Fannie Mae or Freddie Mac collapse posed to the already fragile national economy.” In exchange for the Treasury’s funding commitment, which as of August 8, 2012 amounted to $187.5 billion in total, Fannie and Freddie provided the Treasury with senior preferred stock.

Under government conservatorship, FNMA and FMCC have respectively paid out dividends of more than $31.5 and $26.9 billion in excess of the principal loan they received to the Treasury over the past few years. While the dividend was initially fixed at 10% for the Treasury’s senior preferred shares, the change in initial terms in 2012 to require a variable rate dividend payout has prevented the improvement of FNMA and FMCC’s balance sheets, despite these past returns. So, for the past 8 years, FNMA and FMCC have been required to give all profits to the government in excess of $3 billion. This has not only prevented common and junior preferred shareholder from seeing any returns on their investment, but the building of capital by either GSE as well.

The plaintiffs find this stipulation to be the most egregious offense of all. From a philosophical standpoint they argue that the rights granted in the arrangement between the FHFA, Treasury, and GSEs effectively amounted to the nationalization of a once private company, a fundamental violation of America capitalist history and democratic values.

The government and their supporters argue that the 2009 financial crisis was extraordinary situation and the government was given broad and unprecedented leeway to act and prevent what could potentially have been a repeat of the great depression.

Investment returns aside, the battle for the GSEs which is playing out on the legislative, legal and economic front is a battle for shaping the future of American values.

Disclosure: I am/we are long FNMA/FMCC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Forbes). I have no business relationship with any company whose stock is mentioned in this article.